The House GOP bill improves the corporate tax system. Here’s how to make it even better.

The Tax Cut and Jobs Act (TCJA) bill released by House Republicans contains 429 pages of sweeping tax reform proposals. Buried in that document is lots of good news. House Republicans have taken a careful, serious step toward real tax reform, and their approach cleans up much of the current tax system’s mess and unjustified deductions. But the GOP could do better, by reducing the plan’s toll on the deficit and doing more to encourage work and boost the earnings of workers.

On the corporate side, the good news is that this plan addresses most major problems in our international corporate tax system with thoughtful and well-designed changes. It offers investment incentives and substantial simplification for small businesses. It picks up revenue to finance lower rates by eliminating ineffective deductions and credits, and through a host of other changes that chip away—modestly—at a variety of preferences for insurers, homebuyers, and other narrow interests that simply don’t make sense. These offsets surely will be vigorously protested by those affected, but the pain is widely spread and reasonably imposed. That is how tax reform is supposed to work. And by and large, the bill hits its revenue targets straight up, not with timing gimmicks and accounting tricks.

Unfortunately, this good news doesn’t offset the bad: Republicans have agreed to add $1.5 trillion to the federal debt over the next decade. With the economy finally at or near full employment and the burden of entitlements of today’s retirees about to crash down on the next generation, now’s not the time to blow a hole in the budget—especially not with a tax bill that gives about half its cuts to taxpayers over age 60.

Beyond cost, the most salient flaw is the seeming abandonment by the GOP of the idea that the pathway to upward mobility, middle-class stability, and an individual’s place in his or her community lies in meaningful work and wages. Almost nowhere does the plan support workers who are entering the labor market, working more hours, or earning a larger paycheck. Most low-income workers would see no change—or a trivial one—in their tax burden.

And what gains middle-class workers will see won’t come from more work or higher earnings, but from a handout based on the number of people in their families. The expansion of the child tax credit solves a problem that no economist thinks needs solving: how to cut taxes on upper-income taxpayers without encouraging either work or saving.

Here’s the story in more detail.

The good news: much-needed business tax reforms and a hard look at unjustified tax breaks

On international corporate side, the plan ticks three key boxes:

• It transitions to a territorial tax system that eliminates the ability of U.S. multinational corporations to defer taxes on foreign profits and allows U.S. companies to expand abroad without facing a high rate on their overseas earnings.
• It provides a practical, simplified way to restrain U.S. multinationals from shifting profits and jobs to tax havens by imposing a low minimum tax only on excessive foreign profits (profits above a threshold return on foreign investment)
• It eliminates the current inequitably favorable treatment provided to foreign-owned multinationals operating in the U.S. by limiting their ability to reduce or eliminate their U.S. tax burden by using payments like interest or royalties that are deductible in the U.S. but often never taxable to the foreign parent.

Domestically, the business changes reduce the tax code’s bias toward debt over equity in a simple rational way based on a ratio to business cash flow; encourages businesses to invest by allowing immediate expensing of capital spending (the treatment long favored by economists for economic growth and simplicity) and; simplifies accounting rules and reduces the burden for investment-focused small businesses. And importantly, it finances these changes—in part—by shrinking tax breaks for particular industries like insurance and finance, or for specific constituencies.

On the individual side, the bill wisely takes aim at one of the tax code’s biggest and least-justified tax breaks—housing—and does so in modest, reasonable ways, primarily by curtailing the deduction for mortgage interest. And it chips away at many other tax breaks, too. This is all a step in the right direction.

5 ways to improve the tax bill to help workers and avoid running up the federal debt by $1.5 trillion

So how could the bill be better? Here’s how to write a tax bill that doesn’t add $1.5 trillion to the debt over the next decade and does a better job at encouraging work and investment:

1. Reduce the corporate tax rate (now 35%) to 25%, not 20%. This would limit the increase in the deficit and make the plan less of a windfall to shareholders. It would offer simplification and efficiency gains by reducing the temptation to shelter income in corporate form, or to re-characterize labor income as lower-taxed profits. At a 25% rate, the U.S. would be a more attractive place to build real businesses than elsewhere in the developed world because of the powerful incentives for new investment from expensing and the Research & Experimentation (R&E) credit.

2. Ditch the pass-through break, the one that taxes income of partnerships and other businesses organized in forms other than corporations at a rate lower than it taxes wages. This is a compliance and complexity nightmare. There’s no economic reason to apply lower tax rates on businesses based on how they are organized, no justification to tax entrepreneurial income differently based on how it is earned, and no way to differentiate between one form of business activity and other without onerous rules and intrusive audits. The reform plan already provides large benefits for new investment at these firms through Section 179 expensing for small businesses, cash accounting, and relief from costly accounting treatments, which knock down the effective rate on capital purchases to zero.

Eliminating the break would also help avoid the caricature of “tax cuts for the rich.” No form of income is more concentrated among top-income taxpayers than pass-through business income and the reduced rate would only benefit taxpayers in the highest two brackets (e.g., married taxpayers earning over $260,000). Instead, make the higher level of expensing under Section 179 permanent, celebrate the (revenue reducing) small-business simplifications, and declare victory.

The changes above would reduce the size of the tax cut (by roughly $500 billion and $400 billion, respectively). But if it were really necessary to spend that much, the better approach would be to expand expensing (such as by making the Section 179 changes permanent), increasing the scope of the business simplifications, or by adopting across-the-board cuts in individual marginal tax rates rather than narrowly targeted preferences for pass-throughs.

3. Believe in the value of work. To start with, we should boost the Earned Income Tax Credit (EITC), especially for single workers, and expand the age of eligibility. The credit is an incentive to work and a boost to take-home pay. It’s a proven way to attract workers back into the labor force and reduce dependence on other programs. And it targets one of the strongest correlates of upward mobility: having a job at an early age. Make younger adults eligible, too.

Embrace supply-side economics for families. Scrap the increase in the Child Tax Credit, the standard deduction, the new Dependent Credit, and the expansion in eligibility for the Child Credit to higher-income taxpayers. The last, especially, is wasted revenue, and the provisions do nothing for labor supply or growth. A welfare check for the upper class—what problem is that solving?

Instead, allow families to deduct child-care-related costs of work—a legitimate cost of earning income—and cut taxes on married second-earners so they’re taxed on their own earnings not their spouses. These changes aren’t necessarily progressive because two earner households tend to be higher income, but they are more equitable on different dimensions because they treat workers in married couples more like their unmarried peers, and value the work of second-earners—usually woman—at the same rate as their husbands. Even if a disproportionate share of the tax savings went to higher-income groups, the GOP would have strong arguments for cutting such taxes; they’d be pro-family, pro-growth, and pro-gender equity. Those benefits are far more compelling than the proposed changes to the standard deduction and child credits. They should eliminate them and embrace their supply-side roots.

4. Trim, don’t eliminate, the deductions for state and local taxes. In a reform that is otherwise moderate in the haircut it applies to other deductions and credits, trouncing state and local deductions sticks out. It’s not just that it plays like petty political retribution. It’s also anti-growth for two reasons. First, it raises the marginal tax rate on workers because it denies a deduction for a significant cost of earning income. There’s a reason why the bill doesn’t make the same change for business tax payers. Why should wage earners be treated worse? Second, it raises the tax penalty for working in the most productive areas of the country. Workers in cities with above-average wages—highly productive areas like Silicon Valley, Boston, Denver, or Dallas—pay much higher federal taxes than otherwise similar workers in lower-cost areas just because of our progressive system. That barrier to working in more productive areas is offset, to an extent, by deductions for housing, property taxes, and local income taxes, which tend to be higher in more productive localities. So instead of cutting it entirely, just give SALT a haircut—say, limit the deductibility to a fraction of the total amount.

5. Shift more revenues from corporations to shareholders. Between the lower corporate rate and the elimination of the estate tax, the plan exacerbates one of the largest and least fair distortions in the tax code: the exclusion of capital gains at death. When other countries, like Ireland, lowered their rates and shifted the burden from corporations to people, they did so by ensuring that income was taxed when consumed or at the individual level with dividend taxes, capital gains taxes, and a robust inheritance tax. In short, they lowered taxes on mobile corporations by increasing them on less-mobile shareholders. Such an approach would reduce the deficit, curtail opportunities for tax sheltering and avoidance, and make the plan more progressive. One option is to reduce or eliminate the exclusion of capital gains at death by taxing unrealized gains on stock or carrying over the basis to heirs. The last time Republicans proposed to repeal the estate tax, they replaced it with carry-over basis; President Trump proposed the same on the stump.

The U.S. needs comprehensive tax reform, and the House GOP plan makes a serious effort—especially its improvements to the corporate system. Elsewhere, there is much room for improvement on the individual side by doing more to value work. And the overall plan should be scaled back to avoid the unconscionable $1.5 trillion hit to the federal deficit.